Wake-Up Call for Investors: More Pain to Come This Year

Wake Up Call for Investors: More Pain to Come This YearA couple of weeks ago, Federal Reserve chairman Ben Bernanke testified in front of the House Financial Services Committee and the Senate Banking Committee, adding additional information regarding the central bank’s current monetary policy stance.

There are several things you should be aware of that the Fed chairman stated and what they all mean for the markets.

Bernanke reiterated that the central bank would only reduce asset purchases if the economy continues improving. He then stated that the Federal Reserve might even expand its monetary policy program if conditions warrant such an action.

Now recall that during the last Federal Reserve meeting on June 18–19, simply mentioning the monetary policy program by the Federal Reserve—its purchasing of $85.0 billion per month in fixed income assets—caused a serious sell-off in both the stock and bond markets.

Obviously, investors did not consider the possibility that the Federal Reserve may actually increase their monthly purchases. Personally, I don’t think that’s likely, as there is ample evidence to indicate that the Federal Reserve will begin reducing its asset purchase program later this fall. But the potential is there for an abrupt shift in monetary policy.

Part of the reason for the sell-off was, as the Federal Reserve chairman stated himself, a reduction in excessively risky investments.

This is something I’ve been discussing for the past few months. As I’ve stated many times before, much of the move up in the stock market is not based on purely fundamentals, but investors believing that somehow the Federal Reserve monetary policy program of accommodation will continue driving the market higher.

This ends up being a self-fulfilling prophecy; if everyone thinks the market will go up because they believe a third-party will step in to buy, then we all continue to buy, pushing prices up.

It should be a wake-up call to investors that both the stock and bond markets sold off sharply simply from the discussion by the Federal Reserve that it might begin to reduce only the asset purchase program. There was no talk at all about increasing interest rates, only the reduction of asset purchases in their current monetary policy initiative was mentioned.

Remember: the Federal Reserve made no changes at all in their monetary policy program, and yet stocks sold off. Imagine what will happen when they actually begin making a shift in monetary policy later this year? I think we are looking at a severe sell-off in the stock market.

Considering that we are in the middle of earnings season and many companies are issuing weak guidance, when the Federal Reserve actually begins to make a dramatic shift in its monetary policy program, investors will need a new reason to buy.

If companies aren’t drastically improving their revenues and earnings, and the Federal Reserve is no longer stepping in to buy bonds and mortgage-backed securities, what’s the rationale for continuing to buy? I think many investors will ask themselves this question later this year.